US consumer prices fell in December by the largest amount in six years, reflecting another big monthly decline in gas prices and providing further evidence of falling inflation pressures. The Labor Department said Friday that its Consumer Price Index dropped 0.4% in December, the largest one-month drop since December 2008. It was also the second straight monthly decline in prices with both months reflecting big decreases in gasoline prices.

Consumer prices also fell in the Eurozone in December by 0.2% for the first time in over five years, according to Eurostat, the statistical office of the European Union. Given that consumer prices in the US and Europe went negative in December, we are hearing a lot more talk about deflation – which is a general decrease in prices for goods and services.

A general decline in prices may sound good on paper but when deflation takes hold, it can wreak havoc on the economy. That’s because consumers and businesses have an incentive to delay purchases and investment since prices are expected to fall further. Deflation strangles borrowers because their debts get harder to repay. Just ask Japan.

With the growing concern about the threat of deflation, I am receiving more requests from clients and readers to address it. While I don’t think deflation will take hold in the US anytime soon, it is growing rapidly in parts of Europe, one of our largest trading partners, and elsewhere. So today, we will focus on deflation and the trouble with falling prices.

Before we go there, I would like to discuss two important recent economic reports. The first is last Friday’s unemployment report for January which was widely hailed by the mainstream media. Due to upward revisions for November and December, the report showed that the US economy has generated just over 1 million new jobs in the last three months. But as usual, a deeper dive into the numbers reveals that some problems still persist.

The other recent report we’ll look at is the January Consumer Confidence Index which surged higher than anyone expected. Confidence is now higher than at any time since 2007 before the Great Recession unfolded. Obviously, the plunge in energy prices is the big driver behind the significant increase in confidence since last summer.

January Jobs Report Hailed, But Questions Remain

Forecasters got a pleasant surprise Friday morning as the Bureau of Labor Statistics (BLS) reported the US economy added 257,000 new jobs in January, beating pre-report estimates by about 23,000. The BLS also revised its November and December 2014 new jobs estimates by a total of 147,000 additional jobs created than previously reported.

New job creation over the last 12 months has been the strongest in years. Monthly new jobs averaged 336,000 over the last three months, 291,000 over the last six months and 268,000 over the last 12. Those are the best numbers since 2000. No wonder that the report was so widely hailed.

The headline unemployment rate rose to 5.7% last month, up from 5.6% in December, but the slight increase was largely due to more people looking for work last month, which is a good thing. Remember that the unemployment rate includes both those who are employed and those actively looking for work.

A broader measure of unemployment that includes workers who have stopped looking for jobs as well as the under-employed moved higher as well, from 11.2% in December to 11.3% in January. The employment- to-population ratio was 59.3% up from 59.2% in December and 58.8% a year ago.

The report offered a tentative sign that US workers are starting to extract higher wages from their employers. Average hourly earnings climbed 0.5% last month – up 12 cents to $24.75 – and 2.2% over the past year. The pickup in wages, if sustained, would start to lift Americans’ living standards after years of income stagnation.

The labor force participation rate which had been mired at a 36-year low improved slightly from 62.7% to 62.9%. I discussed the labor force participation rate at length in my Blog on Thursday and explained how it is not simply people retiring that is causing labor force participation to decline. Many working-age Americans have simply dropped out of the labor force.

While Friday’s report was widely hailed in the media, it still left a lot to be desired. While 257,000 new jobs was above the pre-report consensus, it was still down significantly from levels reached in November and December, as shown above. It will take a lot more than increases of 257,000 to soak up all the workers who were sidelined during the Great Recession.

Consider this: President Obama likes to brag that there have now been 51 months of uninterrupted monthly job gains, which have resulted in 10.3 million new jobs. Sounds impressive, doesn't it?

Yet over that same period, the working-age population increased by 11.2 million. By that measure, the country has actually lost ground over the past four-plus years. That’s one reason why the labor force participation rate remains near a 36-month low at just 62.9%, which is much lower than the 65.7% rate at the start of the economic recovery.

Gallup CEO Jim Clifton gave a different context for the jobs report, telling Fox “The number of full-time jobs – and that’s what everybody wants – as a percent of the total population, is the lowest it’s ever been... In the recession we lost 13 million jobs. Only 3 million have come back. You don't see that in [the official unemployment] number.”

Finally, given all the praise Friday’s jobs report got in the media, some analysts worried that Fed policy makers may feel more comfortable starting their long-awaited move to raise short-term interest rates in June or July, a step Wall Street had generally expected to be delayed until September or even later.

US Consumer Confidence Highest Since 2007

In the last week of January, the Conference Board reported that its Consumer Confidence Index rose more than expected last month, jumping to 102.9 from an upwardly revised 93.1 reading in December. The pre-report consensus was for a move up to 95.1, well below the actual number at 102.9.

The Commerce Department report noted that consumers had a more positive assessment of current business and labor market conditions, which contributed to the improvement in consumers’ view of the present situation. Consumers also expressed a considerably higher degree of optimism regarding the short-term outlook for the economy and the labor market, as well as their earnings.

The report also noted that consumers’ assessment of present-day conditions was considerably more favorable in January than in December. Those saying business conditions are “good” increased from 24.7% to 28.1%, while those claiming business conditions are “bad” decreased from 18.9% to 16.8%.

Consumers were also much more positive in their assessment of the job market. Those stating jobs are “plentiful” increased from 17.2% to 20.5%. Those claiming jobs are “hard to get” decreased from 27.3% to 25.7%.

While the report did not mention it, the huge drop-off in fuel and energy prices was the main driver of the much better-than-expected confidence reading last month. The University of Michigan Consumer Sentiment Index experienced a similar spike in January to the highest reading in 11 years.

Falling Prices: What is Deflation & Why It’s Usually Bad

Deflation is defined as a general decline in prices, which sometimes is due to new technologies or innovations that cause prices to fall. More often, however, deflation is caused by a reduction in the supply of money or credit, or by a decrease in government, consumer or business spending and investment. With prices falling, consumers and companies have an incentive to delay purchases and investment, hoping to get an even lower price later on.

The opposite of inflation, deflation has the side-effect of increased unemployment since there is a lower level of demand in the economy, which can lead to a recession or depression. Central banks attempt to prevent severe deflation in an effort to keep significant drops in prices to a minimum.

Declining prices, if they persist, can create a vicious spiral of negatives such as falling profits, factory closures, shrinking employment and incomes and increasing defaults on loans by companies and individuals. To counter deflation, the Fed can use monetary policy to increase the money supply and deliberately induce rising prices – although that is not working well in the current cycle of falling inflation.

Deflationary periods can be either short or long, relatively speaking. Japan, for example, had a period of deflation lasting over two decades starting in the early 1990's. The Japanese government lowered interest rates to zero and printed lots of money to try and stimulate inflation, to no avail. Deflation is dangerous because it can travel across international borders.

Deflation is a Serious & Growing Threat in Europe

Europe’s economy is chronically weak overall, with some countries weaker than others. With demand for goods and services weak, consumer prices in the Eurozone fell 0.2% over the past year for the first time in five years.

Six years after the 2008 financial crisis turned the global economy upside down, a slide in prices now threatens to drag-out the trouble in Europe. The continent’s economies have failed to recover the momentum needed to stimulate slow-but-steady price increases, which most central bankers consider desirable.

So on January 22, the European Central Bank (ECB) unveiled a large QE-like bond-buying program in a once-and-for-all push to revive inflation. As I have written in previous weeks, there is no guarantee that the ECB’s bond-buying program will work. The slide in oil is adding to the deflationary pull and many expect energy prices to drop further in 2015.

Which Countries Are at Most Risk For Deflation

According to Bloomberg surveys with economists familiar with the region, at least eight European countries are likely to experience deflation this year. In Western Europe, those include:

Greece

Spain

Switzerland

Sweden

Eastern Europe also has several nations that are either already in deflation or are expected to go there this year. Those include:

Bulgaria

Croatia

Poland

Slovakia

Deflation in Europe may not be limited to the countries shown above. Germany saw its Consumer Price Index fall 0.3% in January, the first time its inflation rate went negative since September 2009. Italy, the Eurozone’s third largest economy, saw its Consumer Price Index plunge by 0.6% in January.

On January 16, Italy’s central bank slashed the country’s growth forecast for 2015 and warned that deflation would be a risk throughout the year. In its quarterly economic bulletin, the Bank of Italy projected economic growth of just 0.4%, and that is very optimistic. Italy’s economy has not posted a single quarter of growth in the last three years, and the bulletin said the current recession probably continued in the fourth quarter of last year.

Consumer prices in Italy, like the Eurozone as a whole, declined in December. The Bank of Italy forecast that over the whole of this year, prices could fall 0.2% from 2014. So while Italy didn’t make Bloomberg’s list of European countries likely to experience deflation this year, its own central bank warned that the economy is dangerously close.

Finally, the discussion of deflation above is just the tip of the iceberg and is intended only to give clients and readers a general idea as to why deflation is so widely feared. Hopefully, it has been helpful.

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If you are concerned that the market may move lower just ahead, then you owe it to yourself to join us for the webinar with Niemann Capital Management on Thursday, February 26 at 3:00pm CST. The live presentation will last about 30 minutes, and you may ask any questions you have afterward.

Forecasts & Trends E-Letter is published by Halbert Wealth Management, Inc. Gary D. Halbert is the president and CEO of Halbert Wealth Management, Inc. and is the editor of this publication. Information contained herein is taken from sources believed to be reliable but cannot be guaranteed as to its accuracy. Opinions and recommendations herein generally reflect the judgement of Gary D. Halbert (or another named author) and may change at any time without written notice. Market opinions contained herein are intended as general observations and are not intended as specific investment advice. Readers are urged to check with their investment counselors before making any investment decisions. This electronic newsletter does not constitute an offer of sale of any securities. Gary D. Halbert, Halbert Wealth Management, Inc., and its affiliated companies, its officers, directors and/or employees may or may not have investments in markets or programs mentioned herein. Past results are not necessarily indicative of future results. Reprinting for family or friends is allowed with proper credit. However, republishing (written or electronically) in its entirety or through the use of extensive quotes is prohibited without prior written consent.